CA16-5 (EPS: Preferred Dividends, Options, and Convertible Debt) “Earnings per share” (EPS) is the most featured, single financial statistic about modern corporations. Daily published quotations of stock prices have recently been expanded to include for many securities a “times earnings” figure that is based on EPS. Stock analysts often focus their discussions on the EPS of the corporations they study.

Instructions

(a) Explain how dividends or dividend requirements on any class of preferred stock that may be outstanding affect the computation of EPS.

(b) One of the technical procedures applicable in EPS computations is the “treasury-stock method.” Briefly describe the circumstances under which it might be appropriate to apply the treasury stock method.

(c) Convertible debentures are considered potentially dilutive common shares. Explain how convertible debentures are handled for purposes of EPS computations.

The financial calculation that determines the profit generated for each share is known as earnings per share. It is calculated using net income and numerator and outstanding shares as the denominator.

Dividends of preferred shares are deducted from the net income to calculate the earnings per share. If the preferred shares are cumulative, the business entity must deduct the current year’s dividend from the net income, regardless of its declaration and payment. If the preferred shares are not cumulative, the business entity must deduct the dividend if paid or declared.

If the preferred shares are convertible, then it is assumed that they are converted into common stock, and the dividend paid to them is not deducted from net income to calculate earnings per share.

The Treasury stock method is appropriate to apply when options and the warrants that can be converted into common stock are outstanding. The exercise price of such warrants and options is lower than the average price at which the company's outstanding shares can be reacquired.

If convertible debentures are outstanding, then the interest on such debentures is added to net income, which is reported as a numerator in the calculation of earnings per share, and the number of weighted average shares in which the debentures can be converted are added to the shares outstanding reported as the denominator in the calculation of earnings per share.